After a multi-year rally, people should expect lower returns ahead. Nevertheless, investors may still generate some attractive yields through preferred securities-related exchange traded funds along the way.
On the recent webcast, Hone in on Income with this ETF Preferred Strategy, Channing Smith, Managing Director at Capital Advisors, pointed out that global interest rates have plummeted to all-time lows and U.S. treasuries yields are now hovering near record lows. Meanwhile, stock valuations are now hovering near pre-financial crisis levels, with the U.S. stock market CAPE ratio at around 26.57, which suggests that there is greater risk of a drop off or diminished price appreciation ahead.
Continue Reading Below
On the other hand, investors may consider preferred securities that posses characteristics of both equity and debt securities. Jason Jones, Director and Preferreds Strategist at Wells Fargo Securities, explained that preferreds provide equity ownership but without voting rights, are ranked in the capital structure above common equity but beneath traditional bonds, offer yield potential higher than common equity and investment-grade debt, and tend to be concentrated in the financial sector.
Investors and financial advisors are now looking to fund options to gain diversified exposure to the preferred securities space. On a survey of financial advisors attending the webcast, 34.6% of respondents indicated they use preferred securities directly to gain exposure to the space, 29.5% utilized mutual funds and 35.9% use ETFs.
Fran Rodilosso, Head of Fixed Income ETF Portfolio Management at VanEck, argued that investors may also find opportunities in the preferred securities space sans financial exposure. Rodilosso explained that excluding financials has offered similar yield to the broad preferred securities universe, provided greater diversification since financials make up almost three quarters of the broad preferreds universe and generated lower volatility historically than with financial preferreds.
Investors concerned about the yield potential of excluding financials from preferreds need not worry. Rodilosso and Jones found that preferreds ex-financials have generated a 6.2% yield as of September 30, just below the 6.6% yield of high-yield bonds and still more than the 5.7% yield of the broader preferreds universe.
The strategists argued that the preferreds ex-financial space may provide better diversification benefits as a broad preferreds portfolio could cause an investor to be indirectly overweight financials.
“Majority of preferred securities are concentrated in the financials sector, which may add unnecessarily to existing financials exposure from other investments,” Jones said.
Additionally, an ex-financials preferreds portfolio could produce better risk-adjusted returns.
“Excluding traditional financials improved the long-term risk/reward trade off relative to other preferreds and competitiveness with equity and high yield,” Jones added.
Preferred securities provide competitive yield with a higher payout than its common stock and senior debt, has favorable tax treatment as distributions may be treated as qualified dividend income and are senior in structure or rank higher than common stock in the event of bankruptcy.
Potential investors should be aware of risks. For instance, preferreds are subject to interest rate risk and market risks as the securities are sensitive to rate changes and market events. Issuers have the right to redeem the security prior to maturity, causing investors to reinvesting capital at lower rates. Issuers can defer payment of distributions in the event of financial distress, and in some cases, issuers may be unable to meet obligations to investors.
To gain exposure to the preferreds ex-financial space, investors may consider the VanEck Vectors Preferred Securities ex Financials ETF (NYSEArca: PFXF), which has been one of the best performing preferred securities-related ETFs of 2016, rising 11.1% year-to-date. PFXF has also generated an attractive 5.62% 12-month yield.
Financial advisors who are interested in learning more about preferred securities can watch the webcast here on demand.
This article was provided by our partners at ETFTrends.